The Year of the Dog heralds the final innings of the modern world’s greatest economic experiment. 

America’s rampant credit expansion and subsequent implosion in the first years of this century almost brought down the entire global financial system. Radical monetary policies were initiated in 2008 and 2009 by global central banks to address this disaster. Almost a decade later, those emergency policies are now starting to be unwound.

The financial surgery and the ensuing long recuperation are almost over. Or so it seems. The economic medicines delivered after the global financial crisis (GFC) were previously untried and did not deliver the results expected. Growth has been much slower to recover than had been anticipated. The expected rise in inflation that would have allowed central banks to revert to “normal” interest rate policies simply hasn’t happened.

But, driven by historically low interest rates, financial asset prices around the world have hit record highs in many asset classes – bonds, stocks and real estate. In the case of real estate, many governments and central banks have initiated measures aimed to cool down overheating property markets. Hong Kong, Mainland China and Singapore have aggressively used such measures.

So, when we look back on the past decade, low interest rates mean that owners of financial assets have done very well, while middle-income wage earners, savers, pensioners, and those living on fixed income, dividends or interest payments have done relatively poorly. 

The U.S. dollar-pegged currency guarantees that Hong Kong asset prices, particularly real estate, will be more volatile than most other markets. Hong Kong’s interest rates are tied at the hip to those in the U.S., so it cannot raise and lower its interest rates to control its own domestic inflation or real estate prices. Because U.S. interest rates may not match what Hong Kong markets need, it is almost inevitable that at times, interest rates will be lower than needed, and hence help push asset prices higher. 

Or rates may be higher than needed, which can exacerbate downturns and recessions. That was Hong Kong’s fate during almost six years of downturn following the 1997 Asian financial crisis.

Volatility in asset prices means potential volatility in overall economic performance.

Interest rates in the U.S. are rising and set to rise by a further 75 basis points this year, according to market consensus. Conventional economic thinking tells us that rising interest rates are negative for real estate prices, and that falling rates push property prices higher. Unfortunately, it is not quite that simple. There have been many cases in Hong Kong and other markets where falling interest rates have also been accompanied by falling property prices, and vice versa.

Our analysis over the years has shown that real interest rates – not nominal interest rates – are a better predictor of real estate asset price performance. 

The real interest rate is the nominal rate adjusted for inflation. For example, if inflation is 3% and the interest rate is 2.2%, then the real interest rate is minus 0.8% (2.2% - 3% = -0.8%). Over many years, when the real interest rate has been very low, or negative, the real estate markets have tended to rise. And when real rates are significantly positive, that is rates are well higher than inflation, property prices tend to suffer.

Hong Kong has experienced low to negative real rates for almost a decade, so it is little wonder that there has been substantial upward pressure on real estate prices. 

So what is the outlook for interest rates and the Hong Kong economy in the year to come? 

Markets agree almost unanimously that the U.S. Federal Reserve has at least three interest rate hikes in store this year. If Hong Kong banks follow suit, that would likely lift the Hong Kong three month interbank rate (HIBOR) from around 1.25% today to around 2% by year end. This is the base rate that much borrowing is priced off. This is still very low historically, and, with inflation running at a little below 2%, real rates in Hong Kong will still remain very low.

So interest rates, on their own, are unlikely to produce a crash in Hong Kong’s real estate markets or its economy. But this increase may dampen buying enthusiasm and hence slow the rate of price increases, or even produce a modest downturn. This in turn could also produce some slowing of the domestic economy. Hong Kong (like Mainland China) is in its third real estate cycle since the GFC. Most other developed countries are still in their first post-GFC cycle. 

Real estate crashes are normally associated with high levels of leverage, either held by developers or by property buyers. Leverage within Hong Kong is not going to lead to a crash in the city’s property market or its economy. Hong Kong’s major property companies are the most lowly geared amongst their peers worldwide. (This is not the case in the Chinese Mainland). Average loan-to-value ratios in the Hong Kong housing market are around 50%, so there is a very sizable equity cushion available to banks and borrowers. 

But, looking further ahead to 2019, it is not rising interest rates that we should worry about. It is the prospects for a new slowdown; a possible recession in the U.S. 

Why is this a possibility? 

Bond markets are usually a better guide to medium-term prospects for the economy than equity markets. And U.S. bond markets are warning us of an impending slowdown. 

The key here is the spread between yields on long-dated government bonds and short-dated bonds. When that spread is narrow, or even negative (ie if longer term rates are lower than short-term rates – an inverted yield curve), then the market is telling us that expectations of rapid growth and inflation in the medium term is very low. 

The interest rate spread is currently still positive, but it is unusually low. That is telling us that markets do not expect a sharp rise in inflation that would justify sharply higher interest rates. So the chances are that the three anticipated interest rate increases that are currently baked into the U.S. economic cake are all we will get.

Every U.S. recession in recent history has been preceded by an inverted yield curve, where rates on long-dated bonds are lower than those on shorter dated bonds.

While the current yield curve is not inverted, it is unusually flat. This does not suggest impending doom for the U.S. economy, but is certainly flashing a warning signal. So this is telling us that interest rates are not going to soar anytime soon to life-threatening levels in the U.S., and therefore also in Hong Kong. 

A new U.S. recession in the coming two years is a greater risk for Hong Kong than rising interest rates in the near term. That is likely to be the problem we will be grappling with by the time the Year of the Dog transitions to the Year of the Pig.